GreenTraderTax recently dealt with the IRS on an important appeals case involving qualification for trader tax status. Robert A. Green, CPA, and tax attorney Mark Feldman, JD, did some heavy lifting in the tax code and crafted new positive arguments for business traders. We want to share these arguments. We recommend that you engage our firm for help with the IRS, rather than construct these complex arguments on your own.
Normally, our golden rules for qualification for trader tax status focus on IRS-verifiable trading activity like number of round trip trades per year (500), number of days per week with executed trades (three plus), and average holding periods (day or swing trades). The IRS often assesses these concrete factors rather than fuzzy items like taxpayer intention to run a business and claimed time spent in the trading business activity. Take note of our important point about how the “continuous business activity” may trump the frequency of trades. This may constitute a breakthrough for more traders.
In this IRS exam and appeals story, we were focused on the taxpayer’s qualification for trader tax status as a sole proprietor business trader in stock options. As mentioned in earlier blogs (Holsinger case and Recent IRS techniques against traders), it’s more challenging for a stock options trader to qualify for trader tax status than a day trader in securities.
In this IRS exam, we decided to disagree with the IRS agent, who wanted to deny trader tax status for the three tax years being examined. This would also deny Section 475 MTM ordinary-loss treatment, which is conditional on trader tax status. We filed an IRS appeal, where we felt we had a better forum for arguing our case. (Learn more about the IRS exam, appeals and tax court processes in Green’s 2011 Trader Tax Guide.)
An IRS appeals protest letter requires careful construction based on IRS requirements. In it, we laid out our best arguments, and we recently won a favorable result in this appeals case.
Excerpts from our letter
The taxpayer qualifies for “Trader in Securities” (business treatment) for the tax years being examined by the IRS. The taxpayer was successful in the initial years of his trading business and the IRS didn’t take an interest in his tax returns until he suffered significant trading losses and used Section 475f mark-to-market (MTM) ordinary-loss treatment in the three years in question.
IRS Publication 550 Chapter 4 Special Rules for Traders states:
The following facts and circumstances should be considered in determining if your activity is a securities trading business.
• Typical holding periods for securities bought and sold.
• The frequency and dollar amount of your trades during the year.
• The extent to which you pursue the activity to produce income for a livelihood.
• The amount of time you devote to the activity.
Frequency of trades
We believe the IRS agent used incorrect math in his calculation of the “frequency and dollar amount of your trades during the year.” The agent introduced a new concept of requiring two trades per day and he did not properly account for non-business and personal days. The agent also didn’t account for round trip trades properly, the second part of a transaction when options expired worthless. As explained below, the frequency of trades was probably closer to 80 percent and well over case law standards. The agent needed to update his analysis for days traded with just one trade and options expiring worthless.
The dollar amount and risk for trades were also above the amounts needed. For an options trader, there’s much greater risk in trades per dollar amount than in a securities trade.
The agent confirmed that taxpayer spent well in excess of the required time to support business treatment (requirement #4 above). The taxpayer furnished agent with extensive files showing he worked almost every possible non-personal day on his trading business with the same or more time that he worked in his other job. The taxpayer presented files showing he had significant business tools, expenses, resources, equipment, software and services that he used on a daily basis. The agent agreed. The taxpayer used a complex professional options trading program, far beyond the reaches of an amateur investor.
The agent’s flawed math
The agent’s report stated there were 252 days available to trade in 2005. That number is incorrect and he never confirmed it with taxpayer. The correct number provided by the taxpayer is under 240 days. The stock markets are closed on several government-declared holidays.
The agent’s report states that taxpayer did not trade on 79 days. With vacation and sick days, that number is probably closer to 67 days (28 percent). This means the taxpayer executed trades on 72 percent of the days. Add in options expiring worthless and unexecuted initiated trades, and the frequency of trades is well over 80 percent (the agent’s calculations vary wildly at 53 percent). That far surpasses the requirements in case law and any reasonable man test. In Commissioner v. Holsinger, Holsinger had only 40 and 45 percent frequencies. The tax court ruled in favor of the IRS agreeing that Holsinger did not qualify for trader tax status.
Holsinger also only had 160 total round turn trades, whereas this taxpayer on average over the years had closer to 500 or more and that was in line with Levin (who qualified per the court in Commissioner v. Levin).
The agent’s analysis of 2006 is even more favorable to the taxpayer’s position of qualification on frequency and total number of trades. We acknowledge that the analysis is more challenging for the taxpayer in 2007. He began 2007 on the same pace as 2006, but he suffered severe drawdowns and had to reassess and rebuild his capital. He fell under the “pattern day trading” capital requirements, so his broker prevented him making more trades, which he tried to initiate.
The taxpayer was able to rebuild his capital and resumed more active trading in 2008 and 2009. He intends to pursue full time trading; he’s confident he will be able to leave his job soon.
Frequency of trades is a verifiable test, but it has its limitations, as is clear in this case. The math exercise may not account for unexecuted trades, options expiring worthless, monitoring open positions and more. The taxpayer proved he worked in his trading business on the great majority of business days.
The taxpayer certainly has proved his daily trading business time spent and significant business resources used over many years consistently. It’s not fair for the IRS agent to use a “two trades per day” requirement, which leads to an unduly strict requirement in calculating frequency of trades. The agent then used this unprecedented strict requirement to overweigh the other clear factors of business treatment. Frequency of trades is only one factor and case law shows it came about only to verify continuous business activity standards.
The agent’s math on average holding period is also flawed. The taxpayer’s mean and average holding period is far less than the agent’s calculations. Also, professional options trading programs for business traders involve longer holds than day trading businesses. Equating a day-trader case with an options-trader case is apples and oranges. It’s clear the taxpayer is a very short-term options and securities trader looking to profit from daily market movements rather than long-term appreciation (satisfying that requirement).
What constitutes a business day?
A business day is not just days with executed trades, but all days for which business work is done. Business work certainly includes days on which trades were initiated but unexecuted. Examples include market or limit orders not being triggered under market conditions. Business days also include days spent monitoring open positions.
As a swing and position trader, the taxpayer in this case also had many option trades expire worthless (which is part of a credit-spread strategy). These worthless expirations are also executed trades, but they were not counted by the agent.
Think of it this way: A hotel guest checks into a hotel on a Monday and checks out on a Saturday. Monday and Saturday are two executed transaction days of a seven-day week — 29 percent of the week. The hotel guest needed hotel services (towels, room service, etc.) on the part of hotel management and workers Monday through Saturday, five of seven days of the week – 71 percent of the week.
This is comparable to trading — traders monitor trades daily, every day of the week, even on weekends. They often initiate unexecuted trades and stop-loss and limit orders. In my opinion, the IRS should count daily activity for open positions in addition to executed and unexecuted trades.
More trading during certain parts of the year
Business traders commonly have sporadic trading activity levels, but they usually keep working on their trading business consistently throughout the year. Business traders take time off from executing live trades to retool, back-test strategies and demo (simulate) trade, learn new strategies, learn new trading programs and services, conduct research and recover from losing periods. It’s typical to have numerous trades during some months as well as slower months based on changing market conditions and patterns.
The agent pointed out that the taxpayer had more trades in some months than others, but this doesn’t constitute a negative condition. Some tax court cases have stated that a trader only traded for a few months and therefore the trader did not qualify for trader tax status. But, those tax courts are different from this case. In those cases, the taxpayer only traded for a few months, whereas in this case our taxpayer traded consistently for more than ten years in a row.
Continuous business activity is as important as frequency of trades
An analysis of case law over time indicates that if “continuous business activity” can be proven, it may be more important than the last resort argument to count executed trading days to assess frequency of trades. This is important for stock option and other types of traders that work every day on trading, but who have fewer executions than day traders.
In Commissioner v. Paoli, the tax court rightfully did not believe the taxpayer’s claim for time spent in his trading business. The court felt compelled to turn to verifiable factors like frequency of trades, days traded and holding periods, and Paoli came up short on those factors in the eyes of the court.
Conversely, our taxpayer clearly demonstrated continuous business activity and his pattern of regular business trading over many years. This taxpayer traded frequently during the examined years with no sporadic lapses in his trading business. When he did not trade frequently, he was busy retooling and researching. The IRS agent agreed.
The most important point in this case vs. Paoli is that our taxpayer met the continuous business activity; there was no need to apply the frequency of trades (case law). As a back up, taxpayer had sufficient frequency of trades, too.
Produce income for a livelihood
IRS Publication 550 states traders must “pursue the activity to produce income for a livelihood.” The key point of distinction is that the publication only mentions “a” living. It does not say a “primary” or “main” living.
The important point is traders with a full time job can qualify for trader tax status if they meet all the standards. Any business, including a trading business, can have profits in some years and losses in others. The IRS has never claimed that a losing year indicates a business is not set up to generate a profit and a livelihood. The operator of the business intends to pursue a profit and livelihood, but it doesn’t always work out that way.
The agent’s report indicates the taxpayer didn’t make a living from trading, which is incorrect. The taxpayer made more than $100,000 in his trading business in its first five years. He paid for many of his family living expenses from after-tax profits in this business. The taxpayer experienced losses but is back on track in his pursuit of making a living from trading.
Material participation doesn’t apply to trading businesses
The agent started off this exam by raising the “material participation” standards included in Section 469 passive activity loss rules. Under the “trading rule” exception in Section 469, trading businesses are exempt, meaning material participation rules don’t apply to trading business. Rather, the continuous business activity rules apply.
The agent agreed that the taxpayer met these standards anyway. Material participation implies the person is simply participating in the business, but not that he is doing it continuously.
Material participation calls for 500 hours of work spent before a taxpayer can overcome passive activity loss rules and claim business loss treatment. Otherwise, passive losses are offset only against passive activity income and if not, it’s carried over to the subsequent tax year(s). The whole purpose of Section 469 is to deny passive activity losses, not to define whether a taxpayer is engaged in a trade or business.
Nevertheless, Section 469 may be relevant to our issue. Commissioner v. Groetzinger, which is the basis of much of the case law dealing with what constitutes a trade or business, says “to be engaged in a trade or business, the taxpayer must be involved in the activity with continuity and regularity and that the taxpayer’s primary purpose for engaging in the activity must be for income or profit. A sporadic activity, a hobby, or an amusement diversion does not qualify.”
So “continuity and regularity” is clearly related to the standard of 469, though not necessarily the same. Moreover, we argue that if anything, Section 469 is meant to be more stringent than other areas that deal with “regular, continuous, and substantial” involvement.
Hobby-loss rules don’t apply to business traders
IRS agents often try to intimidate taxpayers by arguing that “hobby loss” rules apply to trading businesses. The business-profit intention in Section 183 trumps the three out of five years net business profits test.
Per irs.gov, “Internal Revenue Code Section 183 (Activities Not Engaged in for Profit)” limits deductions that can be claimed when an activity is not engaged in for profit. IRC 183 is sometimes referred to as the “hobby loss rule.” According to IRC 183 “The following factors, although not all inclusive, may help determine whether your activity is an activity engaged in for profit or a hobby:
• Does the time and effort put into the activity indicate an intention to make a profit?
• Do you depend on income from the activity?
• If there are losses, are they due to circumstances beyond your control or did they occur in the start-up phase of the business?
• Have you changed methods of operation to improve profitability?
• Do you have the knowledge needed to carry on the activity as a successful business?
• Have you made a profit in similar activities in the past?
• Does the activity make a profit in some years?
• Do you expect to make a profit in the future from the appreciation of assets used in the activity?
An activity is presumed for profit if it makes a profit in at least three of the last five tax years, including the current year (or at least two of the last seven years for activities that consist primarily of breeding, showing, training or racing horses).”
Section 469 passive activity loss rules were crafted to attack tax shelters, which usually involved passive activities, but did not involve investments. The hobby loss rules are very different — the issue there is whether the activity was undertaken for profit.
Additional note: It is true that most investment activity is undertaken for profit, but we could imagine someone who does day trading for fun — like gambling. We haven’t seen the IRS raise that argument yet.
Trading is a long-term business activity for our taxpayer
The taxpayer’s intention from inception and for the long-term future is to continue this trading business activity. The taxpayer figured he could run a trading business, while still keeping his job a few more years and then make the switch to trading full time once he had a consistent level of profits to make a sole living. Note that a primary means of making a living or a sole living is not required in the tax law.
The taxpayer had hoped to make that full time switch by now. But he experienced significant market losses, after having strong initial profits, which reduced his risk capital below the amounts required for a fulltime business effort. He plans to trade full time within a year or so.
As a West coast-based business executive with flexible hours and oversight, the taxpayer is able to carry on both his job and trading business activities at the same time. He wakes up early in the Pacific Time zone and he trades the Eastern Time zone markets for several hours before going to his job. He monitors, adjusts and trades positions during the day at his job as well. He spends considerable time every day after his job hours and at night and weekends in the trading business too. The taxpayer proved all this to the agent with his work product files and it was supported in the agent’s personal interview of taxpayer as well.
Risk and total proceeds
The taxpayer committed a significant portion of his available risk capital to his trading business and it was material by any new small business standards. He doubled his trading capital with trading gains in his first three years of this business. Unfortunately, he then lost and spent much of those gains and capital. He paid for many living expenses from his trading gains and funded his trading losses with prior trading business gains.
The agent’s argument about insufficient risk capital is a stretch and not within case law. Plus the agent did not cite any case law on these points. Stock option trading concentrates risk, and the total proceeds for an options trader equates in risk terms to a much higher number for a securities trader. The taxpayer’s proceeds were in the multi-millions of dollars; that is not typical for an investor.
We disagree with the agent’s conclusions for proposing accuracy-related penalties for the taxpayer in this case. The agent’s final report says he asked the taxpayer for his occupation and the taxpayer said he was a business trader and had another job too. The agent specifically asked about the taxpayer’s W-2 job, not his tax status, which is clearly reported on the his tax return (job and business trader).
The IRS has not clearly defined the objective tests for qualification for trader tax status, leaving this difficult job to the courts. Tax court opinions vary in wide ranges of objective results. It’s outrageous for the agent to assert that the taxpayer was acting in bad faith in taking his tax return posture; which again the taxpayer is correct in doing so. Even if a court would rule in favor of the IRS, it’s clear this case is a close call, not an example of bad faith.
Moreover, the agent misconstrued the reasonable cause exception of relying in good faith on the advice of a tax advisor. Treas. Reg. section 1.6664-4(c) states, “All facts and circumstances must be taken into account in determining whether a the taxpayer has reasonably relied in good faith on advice (including the opinion of a professional tax advisor) as to the treatment of the taxpayer (or any entity, plan, or arrangement) under Federal tax law. For example, the taxpayer’s education, sophistication and business experience will be relevant in determining whether the taxpayer’s reliance on tax advice was reasonable and made in good faith.”
The agent based his conclusion of bad faith upon the fact that the taxpayer replied to the question of “what do you do for a living?” by saying he’s an administrator of a foreign-owned company. The agent presumed that in answering such, the taxpayer knew full well that he is not a business trader. However, the taxpayer can be a business trader for tax purposes even if his primary job is that of an administrator. Moreover, the taxpayer was given this advice by Robert Green, the author of The Tax Guide for Traders and one of the most prominent trader-tax advisors in the country. The taxpayer reasonably relied in good faith on the advice of a tax professional even if the tax professional was wrong (which he was not).
The agent’s report is based on incorrect analysis, and we disagree with his conclusion claiming the taxpayer does not qualify for trader tax status. We recently settled this IRS exam with the appeals officer and won a favorable outcome including trader tax status and ordinary loss treatment for 2005 and 2006. The IRS agent initially denied trader tax status and all ordinary trading losses for 2005, 2006 and 2007. We look forward to using these and other arguments in tax court at a later date, and hopefully setting better precedent for all business traders.